So-called “superangels,” business angels who have gone pro and raised a fund from institutional investors, are changing the startup investment landscape and, some say, not for the better.
The superangels have basically brought two different kinds of concerns, which we’ll see are related:
- That superangels are bidding up valuations for startups, particularly consumer web startups, to an insane point, and
- That superangels are investing and encouraging companies to just “flip,” i.e. get acquired for eight figure amounts that would make the founders rich and give the angels a good return, but are too small to matter for VCs and to build the huge, iconic companies that startup founders are supposed to want to build.
All these worries came to a head when Michael Arrington accused several prominent Silicon Valley superangels to collude to keep startup valuations down. But nobody’s pointed out why doing such a thing would be so attractive to superangels. After all, you would think that any investor, angel, superangel or VC, would want to invest in the next Google or Facebook.
But besides the additional risk in going for the multibillion dollar outcome and how tens of millions of dollars can completely change the life of a young startup founder, there’s also a reason why keeping valuations down and going for the flip can appeal specifically to superangels: it’s because superangels are evaluated according to their Internal Rate of Return (IRR) and not on a cash multiple basis.
There’s a crucial difference between the two. Cash multiple just says how much cash is returned versus how much cash was invested. But IRR takes into account those returns over time. In other words, a huge payout after a long period of years can work out to a lower IRR than smaller, but quicker, payouts that end up returning less cash overall to investors. (For an example, see this post by Andrew Parker, a VC at Spark Capital.)
Superangels, like VCs, raise money from institutional investors called Limited Partners (LPs), like big banks, pension funds and university endowments. And these LPs don’t just invest in venture funds, they invest over a very large range of asset classes, from the pedestrian (stocks, bonds) to the exotic, like private equity. LPs use IRR to compare the returns over all these different asset classes, and professional venture investors, whether traditional VC or superangels, need to have a better IRR than those other investments. Superangels with better IRRs can raise bigger funds and/or demand higher fees.
By focusing on the speed, and not just the size of the exits, superangel funds can give much better IRRs to their investors than most traditional VCs. (Paul Graham made that point here.)
And the macro environment favours this, too. Companies take forever to go public now which, all else being equal, will lower VCs’ IRR. Meanwhile it’s much easier for superangels to sell their stakes in big startups through secondary sales and/or DST-type deals.
But for this approach to work, the valuations at which superangels invest have to be low. If you’re going for an eight figure exit, a lower investment valuation is going to matter a lot more than if you’re going for a 10 figure exit.
Of course, we’ll probably never know if there really was (or is) “collusion” to bring early stage valuations down, and we don’t doubt that many superangels want to build huge, disruptive businesses and not just flip. But we think it’s important to point out that there’s an economic logic to superangels wanting to “flip.”
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